Commentary

Investors uneasy over Fed’s next move

Commentary: Options market reveals mood of global investors

By

MichaelCasey

Columnist

The vocabulary of the options world — “gamma,” “delta,” “implied volatility” — is enough to scare away most retail investors even before they’re forced to figure out how these complex derivatives are priced.

But sometimes there’s no better place than the options market to gauge the mood of global investors. We are currently in one of those moments.

Right now, the pricing for options on both stocks and currencies, which are often used to hedge against adverse movements in those underlying markets, is telling us that investors are not so much scared of putting money at risk as somewhat more cautious about doing so. Uncertainty, not fear, is the name of the game. And in that sense options offer a powerful indicator of how markets remain in the thrall of the world’s biggest central banks.

Implied volatility — the standard pricing benchmark in the options market, expressed in percentage terms — has risen over the past two weeks in a number of bellwether markets, proof that investors are buying protection against the risk of losses. For options that expire within one month on dollar/yen contracts, for example, implied volatility is now above what it jumped to in the wake of Japan’s earthquake in March 2011 and is at its highest since April 2010.

Just as important, the upward path to these higher levels has been a gradual one, not a sharp spike. A similar pattern appears in charts for the Chicago Board Options Exchange Volatility Index
VIX, +32.45%
, a broad gauge of stock option pricing also known as the VIX. Previous highs in the VIX’s six-month chart appear as searing, short-lived peaks that quickly give way to declines. Those past episodes usually coincide with sudden, news-driven selloffs in the stock market where investors got temporarily spooked by some external development and so turned to options to protect against further losses, only to find the moment passing and the newly higher volatility levels triggering a wave of opportunistic selling.

But the more gradual increase in volatility this time around has mostly coincided with continued buying of U.S. stocks, much as dollar/yen, despite some biggish swings, has mostly held to levels above Y100.

What’s happening? Well, investors know “you can’t fight the Fed” — or for that matter, the BOJ. So with these two giant central banks for now committed to a combined $155 billion in monthly bond purchases, it’s hard not to keep buying stocks or selling the yen. That money has to go somewhere, after all, and few professional money managers can stomach being beaten by the market for too long. If everyone else is buying, so must they.

Yet markets are now also abuzz with the prospect that the Fed might “taper” its bond buying, an idea traceable to Federal Reserve Chairman Ben Bernanke’s comment before Congress last month that the Fed might start dialing down its purchases “in the next two meetings.”

Yet that hint is not enough to prompt a wholesale exodus from risky market bets. Bernanke himself added the caveat that tapering could only begin if economic data were sufficiently strong. And given that the Institute of Supply Management reported a contraction in the U.S. manufacturing sector in May, the economy still appears to fall short of that requirement. In fact, various Fed officials stress that the Fed could just as easily increase bond-buying if conditions worsen. The solution to this maybe/maybe-not scenario: Keep buying stocks, but buy protection as well.

And do this regardless of how sluggish the economy is.

Meanwhile, the situation in Japan breeds a similar response. Investors are naturally worried that the Nikkei 225’s 58% gain since October and the yen’s 25% loss versus the dollar leaves room for an even bigger correction than the periodic unwinds we’ve seen over the past two weeks. But with the BOJ still planning on dumping Y7 trillion in fresh into the bond market every month, there’s still inherent need to put a lot of cash to work. Again, the solution is to boost protection.

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